Factor-Based Hedge Fund Replication with Risk Constraints

Abstract

In this paper, we propose a method for hedge fund replication using a factor-based model supplemented with a series of risk and return constraints that implicitly target all the moments of the hedge fund return distribution. We use the approach to replicate the monthly returns of ten broad hedge fund strategy indices, using long-only positions in ten equity, bond, foreign exchange, and commodity indices, all of which can be traded using liquid, investible instruments such as futures, options and exchange traded funds. In out-of-sample tests, our approach provides an improvement over the pure factor-based model, offering a closer match to both the return performance and risk characteristics of the hedge fund strategy indices.

Keywords: Hedge fund replication; Hedge fund portfolio optimization; CVaR; CDaR, Upper and lower partial moments.

JEL Classification: G23, G24,G11, C61, C63, C02